Thomas Aubrey / Nov 2015
The long awaited Action Plan on Building a Capital Markets Union was published by the European Commission on 30 September. Commissioner Hill should be applauded for the scope of the plan and also the pragmatic nature of his approach. He has constantly stated that he wishes to focus on whatever is required to drive growth and jobs, taking a bottom-up approach rather than grandiose plans per se. However, the proposals to improve the funding of businesses in order to drive jobs and growth need to be far more focussed if they are to solve the problem at hand.
The challenge with any policy debate about how to improve the flow of capital to SMEs is that the needs and desires of SMEs for financing are diverse and often have little in common with each other. As such the Action Plan could do with identifying which segments of the SME market are faced with severe funding constraints, and crucially what impact they might have on the economy in terms of growth and jobs if this financing gap were to be bridged.
Policy Network has identified the group of fast growth and innovative businesses as having a far greater impact on the rate of growth and job creation than all other SME segments. Furthermore, this cohort of firms is severely capital constrained as they tend to have little collateral and have often not completed their journey to breaking even. This generally means that these firms need equity rather than debt to fund their expansion, and there is a dire shortage of equity financing across the EU.
The action plan addresses this at a very high level stating that the Commission will launch a package of measures to support venture capital and equity financing. But if these policies are to be successful, the underlying problem as to why there is a dearth of equity financing needs to be correctly diagnosed.
The major reason for the fall in institutional investment in venture capital is that the returns are around zero. And whilst returns are close to zero, it is not clear why institutional money will increase exposure to this asset class. Institutional investors in the most advanced VC market in Europe, Sweden, have been shifting their asset allocation away from venture capital towards private equity because VC returns have been so lousy. Until the issue of low returns has been addressed this is unlikely to change.
The encouragement of retail money into this sector should also be of some concern given that average returns are zero, which means many retail investors will lose money rather than gain money. This is because fast growth and innovative firms are riskier to finance. Data collected and analysed by Policy Network shows non-performing loans to young, innovative businesses to be just under 40%, with business angel losses at 44%.
Given this market dynamic, a better business model for many venture capital firms would be to provide both equity and debt financing for fast growth firms. The net interest margin from loans enables investors to cover their operational costs, with the equity portions in successful firms driving profitability. Financing for these loans could be provided without a cost to the taxpayer through a small business investment scheme managed by the European Investment Fund. The Juncker Plan’s allocation of €5bn for SMEs could be better utilised in supporting investors with low cost, long term loans.
Finally, what often matters more for the success of these innovative and fast growing firms is not just capital, but expertise. As such the Commission ought to recommend member states to prioritise tax incentives for business angels, who have the expertise, to drive up levels of investment. The Commission should also look to guarantee the financing of these tax incentives if member states are unable to afford an increase in short term deficits. Once local investment levels have reached a critical mass, developing pan-European passport products would also be beneficial.
The Capital Markets Union is a fantastic opportunity for the commission to make a difference to jobs and growth across the EU. However, for it to be successful it needs to focus on those fast growth and innovative firms that truly make a difference and are capital constrained. The Commission must prioritise an equity revolution across the EU. That means promoting best practice for tax incentives for business angels, and leveraging the capability of the EIF to provide long term loans to equity funds to help make the venture capital business model profitable.